Losses in the stock market are classified as either short- or long-term capital losses. Such losses could reduce your taxable net income and therefore your tax liability. Various tax laws dictate how you must handle these deductions. Short-term capital losses, however, are first written off against short-term -- also sometimes called "ordinary" -- gains.
Short Term Capital Loss
A capital loss occurs when you sell a capital asset, such as a stock, bond, mutual fund or real estate -- excluding your primary residence -- for less than what you paid for it. Commissions and other expenses incurred during the purchase or sale are added to the cost of the asset and thereby increase the loss. A capital loss is considered short-term if you sell the asset less than a full year after you bought it.
Deductions from Short-Term Gains
You can deduct, or write off, short-term losses from ordinary short-term gains. Assume that you have traded three stocks over the course of the year: you held stock A for 10 months and lost $7,000 from this trade; you held stock B for 3 months and made a profit of $2,000; you sold stock C for two years and made $1,000. You can deduct $2,000 of the loss from the sale of stock A from the profit of stock B. There is no limit to how much of your short-term losses you can deduct from your short-term gains.
Deductions from Other Gains
If you are still left with a short-term loss after deducting it from short-term gains, you can then deduct the remaining amount from long-term capital gains. Following the same example, you are left with a $5,000 short-term loss after applying it to short-term ordinary gains. You can then apply another $1,000 of this loss to long-term capital gains, which wipes out all long-term gains as well. This leaves you with $4,000 in short-term losses. You can deduct $3,000 of this sum from any other income, whose source can be anything from wages to royalties.
If the short-term capital loss was substantial, you may have an unused portion after deducting it from capital gains and then applying an additional $3,000 of it toward other income. In such cases, you can save -- or "carry over" -- the remaining loss for next year. Next year, you add this sum to your other short-term capital losses and apply the same rules.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.